The True Costs of Brexit Are Beginning to Add Up

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The British pound’s fall from grace over the past four months has served as a reminder that the United Kingdom’s exit from the European Union will be a messy ordeal. Since the June 23 vote, the value of the pound has declined a staggering 18%. While a cheaper pound is expected to make British exports more competitive, it may push inflation much higher than the central bank intends. This might place significant strain on the economy.

The pound-dollar exchange rate briefly plunged to a low of $1.18 on October 7 in belated response to Prime Minister Theresa May’s call for a “hard Brexit.”[1] The pair has since recovered above $1.22. By comparison, the pound-dollar exchange rate was trading around $1.54 this time last year. In short, the British pound is telling the world that UK assets are worth less – much less – than they used to be. This includes everything from land, property, bank deposits and government debt. With the exception of London’s FTSE 100 Index, whose components are highly exposed to international markets, the UK economy is worth less today than it was before Brexit.[2]

Inflation recently jumped to an annualized 1% in September from 0.6% in August. That was the highest level in almost two years. Clothing saw its biggest price increase since 2010. While the Office for National Statistics has stated there was “no explicit evidence” that faster inflation was due to a weaker pound,[3] the Bank of England (BOE) has warned the markets of more aggressive price pressures. The BOE believes inflation could “sharply” overshoot the 2% price target, partially due to stimulus measures announced by the central bank following the Brexit vote.

“All in all, partly due to this package, partly due to the underlying momentum in the economy, partly due to other changes in the economy, it does look like the days of inflation bouncing around zero are long gone,” BOE policymaker Kristin Forbes said in a conference hosted by Poland’s central bank earlier this month.

“Inflation is already picking up. It will pick up even faster and we are likely to overshoot our 2% inflation target perhaps sharply in the next two years,” she added.[4]

One of the biggest impacts of Brexit has been the response of the financial markets to jittery news headlines. Once again we go back to Prime Minister May, who made no reservations about Britain needing to look beyond Europe. Mrs. May said Britain will not make a “trade-off” between controlling immigration and retaining access to the single-market, something Brussels expects of the UK should free-trade remain on the table.

“Let me be clear, we are not leaving the EU today to give up control of immigration again and we are not leaving only to return to the jurisdiction of the European Court of Justice. As ever with international talks, it will be a negotiation. It will require some give and take…” May said in an October 3 speech.[5]

Those comments sent the British pound to fresh lows and jolted the financial markets from Tokyo to New York. Investors may expect a lot more knee-jerk reactions to negative news headlines this spring when the UK formally notifies Brussels of its intent to exit the EU.

On the whole, the British economy has fared better than expected following the Brexit vote. Britain’s manufacturing, services and construction sectors all expanded faster than expected in September. A falling pound appears to have lured international shoppers to the UK, stimulating consumer spending and retail sales. The UK is now on track to avoid recession in the latter half of 2016. The International Monetary Fund (IMF) has also upgraded its 2016 growth forecast slightly. However, it also lowered its guidance on the UK economy next year.

Back in August, the Bank of England made its largest downgrade to GDP growth ever as it lowered interest rates and expanded its bond-buying program. The BOE expects the UK economy to grow just 0.8% in 2017, down from a previous estimate of 2.3%. The year 2017 is expected to be the first major test for the post-Brexit UK. Perhaps then the full costs of Brexit will start to be known.

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